Matthew Casey: The downward economic spiral continues

Matthew Casey

Wednesday

Nov 26, 2008 at 12:01 AMNov 26, 2008 at 7:06 AM

Just before the dot.com bubble burst, “experts” were peddling books with titles like “Dow 36,000,” “Dow 40,000” and even “Dow 100,000.” According to a 1999 book review, “it’s not a question of if the Dow Jones Industrial Average will blast into the financial stratosphere, but how high it will go.”

Just before the dot.com bubble burst, “experts” were peddling books with titles like “Dow 36,000,” “Dow 40,000” and even “Dow 100,000.” According to a 1999 book review, “it’s not a question of if the Dow Jones Industrial Average will blast into the financial stratosphere, but how high it will go.”

In retrospect, I guess “Dow 7,800” probably wouldn’t have sold as well.

In 2006, David Lereah, chief economist of the National Association of Realtors, wrote a book called “Why the Real Estate Boom Will Not Bust and How you Can Profit From It.” In May, other “experts” predicted that gasoline would quickly achieve a permanent plateau of over $5 per gallon and climb to as high as $7 or $8.

As recently last summer, government officials were still worried about inflation. Times change. Today, the specter of deflation is making economists squirm.

Inflation erodes the value of money over time, but limited inflation is generally a sign of a healthy economy. When business is robust, unemployment drops, the demand for workers increases wages and prices rise. During inflationary periods, the purchasing power of money is never greater than the present, so consumers have an incentive to spend their money as they get it and keep the economy chugging along.

As long as inflation doesn’t spiral out of control, we see it as a tolerable consequence of a growing economy. But deflation, the economy’s other evil twin, can grind the economy to a halt.

When confronted with a shocking economic downturn, consumers defensively cut spending to prepare for tough times ahead. The law of supply and demand dictates that businesses respond by lowering prices to entice consumers. Typically, consumers respond by buying cheaper goods and services and the economy recovers.

But when things are really bad, falling prices can become self-sustaining and make things exponentially worse. Unlike inflation, price deflation increases purchasing power over time. This sounds superficially appealing, but over an extended period, deflation can be debilitating.

Consider this: you bought house in the San Francisco Bay area last year for the median price of $631,000. After putting down 20 percent, you’re left with a mortgaged balance of about $500,000. Since then, the economy soured, you were laid off and you need to sell.

Today, your house is worth just $375,000. At that price, you’ll lose everything you put down and you’ll still owe the bank another $125,000. But that’s if it sells at that price.

Credit is tight, foreclosures are flooding the market and dropping prices scare off buyers who assume they’ll begin losing money the minute they pass papers. So the price keeps dropping, buyers keep balking and you get deeper in the hole.

This scenario isn’t limited to the housing market. Consumer prices in October declined by the greatest amount ever recorded and prices are falling around the world. Consumers wait while prices keep dropping — and while prices keep dropping, consumers keep waiting. In the meantime, the economy stalls.

For all its assumed power, the government’s options for dealing with the economy are essentially limited to manipulating interest rates and regulating the money supply. Low interest rates mean cheap money for investment: businesses grow, jobs are created, incomes rise and spending increases. But deflation diminishes the positive impact of low interest rates — why borrow money with interest to spend today when costs will decrease if you do nothing but wait?

If deflation continues to loom as a legitimate threat, the government may print more money and hope that the resulting inflation reverses the trend.

Prices have yet to drop for an extended period, so deflation is still only a threat. Hopefully, we are merely in the midst of some painful price corrections caused by a series of irrational market bubbles. With luck, the bottom will be reached and investors, lenders and consumers will take their heads out of the sand and start moving money around again.

How will all of this play out? Don’t bother asking the experts — they’ll be waiting to find out just like everyone else. If any of them really knew what was going on, we’d never be in this situation in the first place.

Read more from Matthew Casey at matthewcasey.net.

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